Economic Margin Analysis: Attractive French Companies from the SBF 250

AFG’s Economic Margin (EM) methodology EM = Cash Flow - Capital Charge/ Invested Capital (what a company earns above or below its cost of capital) has proven to be a very useful indicator of a company’s true economic profitability and is consistent across different companies, sectors, styles and even across countries. Since a company’s EMs and expected changes in EMs have proven to have a high correlation with market performance, an analyst should start their analysis by identifying good quality companies using AFG’s Economic Margin methodology screening for companies that are expected to improve their EMs. After a company quality check the next step in evaluating a holding or potential holding is to determine what price the stock should be trading at using AFG’s modified discounted cash flow valuation model.

Below is an analysis of the companies within France’s SBF 250 index. This exercise is focused on identifying companies expected to improve their EM’s at a higher rate than their sector peers. The 10 companies listed are projected to have an EM improvement for next year better than sector peers as well as have an attractive valuation based on AFG’s valuation model. All 10 companies would be considered a Hold or better using AFG’s default investment opportunity signal Attractive/Hold/Unattractive.

The chart below is a view from AFGviewGlobal.com and the Value Expectations (VE) interface. VE helps users understand the embedded expectations priced into a stock in addition to providing a default valuation of a firm. The example provided below is MR Bricolage SA which currently looks undervalued and is expected to improve its Economic Margins better than its sector peers the first forecasted year. Also provided below is a map of the VE interface that will help to better understand the main inputs users can manipulate.

Value Expectations allows one to efficiently build out pro-forma scenarios and come to quick conclusions on a company’s intrinsic value. AFG’s valuation model helps identify potential torpedoes and avoid stocks that the market has unrealistic expectations price into them. Our valuation approach takes a very robust DCF model and translates it to value driver’s money managers are most familiar with such as sales growth, EBITA margins, and asset turns.

AFG’s Value Expectations interface provides clients a platform to better understand economic profitability, and at the same time understand the performance a company must deliver to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low.

After determining if a company is a valid investment opportunity, users have the flexibility to adjust expectations based on their own research, build out pro-forma financial scenarios, and arrive at an NPV target price.

In addition, the VE interface has all the key theoretically components of a well-thought-out valuation model, which takes into consideration the appropriate risk, with a market derived discount rate (MDDR) that is adjusted for size and leverage. Competition and perpetuity issues are also taken into account, using company specific Competitive Advantage Periods (CAP).

By gaining a better understanding of the embedded expectations built in to security prices, relative to what a company has delivered historically, can provide insight into the Sales Growth, EBITDA Margin, and Asset Turnover a company must deliver in the future to justify its current trading price. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.

Components of AFG’s Value Expectations EM Pro-Forma Chart:

Economic Margin

The Economic Margin (EM) Framework was developed to evaluate corporate performance from an economic cash flow perspective and is an alternative to accounting-based valuation metrics. EM measures the return a company earns above or below its cost of capital and provides a more complete view of a company’s underlying economic vitality.

Value Drivers

Sales Growth - Annual % increase or decrease in sales.

EBITDA -Operating Income + DD&A

Asset Turns - Total Sales/Total Assets

CAP – Competitive Advantage Period

The CAP field represents the Competitive Advantage Period calculated by AFG. The CAP value represents an exponential decay expressed in number of years. The decay range is between 7 and 39, with the average company having a 17-year CAP period. For each company, AFG performs a four-factor regression on historic Economic Margin (EM) levels to determine how attractive the company’s line of business is to competition. The four factors consist of profitability, variability, trend, and invested capital.

• Defines the terminal value period

• A number of years over which EMs trend to zero.

• A four-factor regression based on a company’s profitability, variability, EM trend, & size.

Cost of Capital

The COC field represents the Cost of Capital calculated by AFG. AFG calculates COC by taking a subset of companies (2200 industrial, 150 utility, or 300 financial) meeting certain qualitative criteria. For each individual company in those subsets we solve for the discount rate that makes them fairly valued today. We then rank order those discount rates and select the median discount rate to represent a typical firm’s COC in the marketplace. Each company is then adjusted from the market-derived discount rate for its size and leverage characteristics. Thus, the largest most levered firms have the smallest COC; and the smallest most highly levered firms have the highest COC.

• Market Derived Discount Rate (MDDR).

• Adjusted for Size and Leverage on company specific basis.

• Expressed as a nominal rate

• Understand the performance expectations embedded into today’s stock prices.

• Build out Pro forma Financials.

• Determine NPV target price based on your assumptions.

Target

Target represents the NPV target price based on the levels of Economic Margin being projected in the model. The three value drivers (Sales Growth, EBITDA %, and Asset Turns) determine the levels of Economic Margin (EM) being projected in the model.

Upside

Upside represents the percent upside or downside based on Price (last night’s closing price) and Target.

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Since 1996 The Applied Finance Group (AFG) has been a reliable provider of quality research, helping its clients identify and understand which investments to consider and which to avoid, using AFG’s Economic Margin (EM) methodology. As the leader in value based research, AFG helps investors understand a company’s true economic profitability, and AFG’s proprietary valuation model allows you to take advantage of mispriced securities in the market. AFG has recently expanded its EM methodology and valuation model to over 20 countries and 27,000 companies, providing the same quality of research that many investors in the US have relied upon for the last 14 years.